Zero-Volatility Spread - Z-spread

Z-spreads, a.k.a. zero-volatility spreads, can be intimidating at first. But they’re really just big softies underneath, so don’t fear them. Let’s go over some basics before jumping into exactly what they're all about.

First: when we’re talking z-spreads, we’re usually talking bonds. Not James Bond...the boring kind you get from the government. Now, when you’re looking at whether or not it’s worth it to get a bond, you should calculate the present value of cash flow on the yields you’d get from the bond (which comes from the “coupon rate” of the bond).

What does that mean? Well, if you do some math with nominal numbers and the coupon rate (i.e. "if I get x% fixed amount from this bond each year, by the maturity date of the bond, I’ll have $y amount...sounds great!"), you’re forgetting that money today isn’t worth the same as money in the future. If that were the case, burgers would still cost a nickel. If Grandma thought her ten nickels would buy her ten burgers today, she’d be sorely mistaken and disappointed. So...don’t do that.

Enter: Treasury spot rates. Treasury spot rates are based on quoted prices for bonds on bond settlements, so they take into account anticipated changes coming to the market. You can use Treasury spot rates, which take into account market changes and inflation, and voila! You have your discounted cash flow for the yields you’d be getting on this bond.

Okay, so now that you’ve discounted for inflation for the yield for each year of this bond you might buy, you have a more realistic sense of returns, which is less than with nominal, fairy-tale numbers that forget inflation and ignore market ups-and-downs.

If you add your discounted cash flow from each year all together, you get the total value of the bond, i.e. the total money in your pocket (in theory) from this bond. Cool beans. So now that you know the benefit, what’s the cost? Is it worth it? Well, if you look at the market price and compare it to the benefit you get, there’s likely a difference there. The market price might be $900 and your overall value of the bond might be $1,200. If you add to the discount rate (the Treasury spot rate) at each year until the value of the bond is the same as the market price, you have the z-spread.

To sum up: the z-spread is a constant that makes the market value of a bond equal to the present value of its cash flows when you add it to the Treasury spot rates for each year (or each period, which might not be a year). The higher this z-spread percent, the more money in your pocket. The lower it is, the safer it might be...but the worse deal it is, too.